Election 2008: The Achilles' Heel of Obamanomics

By Martin HutchinsonContributing Editor

Presidential hopeful, Barack Obama, recently told The Wall Street Journal that he intended to lift the United States out of recession through a burst of government spending on infrastructure and a venture capital fund for the new energy sector.

Obama has made few economic mistakes in his campaign – he avoided the economically counterproductive proposal to cut petrol taxes between Memorial Day and Labor Day backed by both John McCain and Hillary Clinton – but he has shown his Achilles' heel with this proposal. There may be many reasons to increase government spending, to better defend America or to introduce a more generous healthcare plan or other social programs, but helping the economy recover is not one of them.

In the long run, higher government spending makes the economy worse.

This may seem heretical to those brought up on the doctrines of John Maynard Keynes. Or maybe it's just simply reactionary – a position to be expected from a Reaganite mossback who fails to recognize that the world has changed.

But the Keynesian doctrine that public spending can boost an economy out of recession fails to distinguish between two effects of a public spending surge: a larger budget deficit and a transfer of resources from the private to the public sector.

A larger budget deficit does indeed boost the economy in the short term, as expenditure increases, regardless of whether that deficit is attained through tax cuts (such as this year's "stimulus") or higher spending. However, it also increases public debt, thus incurring greater costs for future years, and in times of tight liquidity (which we have not seen since the early 1990s) it can force up interest rates, "crowding out" financing in the private sector.

Obama has not recommended a larger budget deficit; indeed it is difficult to believe that he could. The annual deficit is already approaching $500 billion, and the revenue effects of the 2008 slowdown have not yet been felt, since corporate taxes and individual taxes on large bonuses are both paid in arrears – it will thus be early in 2009, about the time of Obama's inauguration, if he makes it, that the true effect of the slowdown is seen in a deficit that will almost certainly yawn beyond $500 billion. Obama may save money by withdrawal from Iraq (though that withdrawal might well take a considerable time) but he also plans to spend money though his health plan; there will thus be no money to spare.

The problem arises with higher public spending, the transfer of resources from the private sector to the public sector, however it is financed.

By definition, private sector spending is economically optimal; it reflects the owner of the resources' view as to the best use of those resources. Public spending, on the other hand, cannot be economically optimal except by accident, because it represents bureaucrats, however well meaning, making choices on behalf of others, which are unlikely to coincide with the preferences of the beneficiaries.

On the investment side, public sector investment frequently results in losses, because of the lack of market signals showing the investor where to put its (or rather the taxpayer's) money. Finally, in a political system like the United States, where lobbying is powerful, resources that flow through the public sector are themselves subjected to a tax of unnecessary boondoggles and pork-barrel spending, further inflating public-sector costs compared to the private sector.

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This is not just theory. Statistical studies using Organization for Economic Cooperation and Development (OECD) public spending and growth rate data have shown that both the level of public spending (in terms of gross domestic product (GDP)) and its rate of increase are inversely correlated with economic growth, with the combination of the two factors explaining slightly over half the differences in growth rates between different countries and different time periods.

This is intuitively sensible; a large public sector starves the productive private sector of resources, stifling productivity growth, while a rapidly growing public sector sucks up all the new resources generated by economic growth, further starving private enterprise.

There are numerous examples of public sector growth stifling economic growth. Back before modern statistics, the sharp rise in public spending under thirty-first President Herbert Hoover (which was extraordinarily matched with a huge tax increase in 1932) was a major contributor to the depth of the Great Depression.

Meanwhile Britain kept public spending under control, cutting public sector wages by 10% in 1931 when times for all were hard, and had both a shallower Great Depression and a much shorter one; output was above its 1929 level by 1934 and grew rapidly from then on, well before serious rearmament began.

Well into the era of modern statistics, France and West Germany both enjoyed "economic miracles" in the 1950s and 1960s, then growth dropped sharply – in the early 1970s for Germany and the late 1970s for France.

When you examine the statistics you find out why.

The leftist Social Democrat Chancellor Willy Brandt increased German public spending by 10% of GDP in 1970-75. West Germany then enjoyed slow growth in the 1980s before it entered stagnation through a further increase in public spending by 7% of GDP in 1990-96 (related to the reunification with East Germany).

Then there's Japan. The "Lost Decade" of the 1990s would have been grim anyway, because of the collapse of the 1980s stock market bubble, but the Japanese government certainly didn't help by pushing public spending up by 8% of GDP between 1990 and 2002. Only after Junichiro Koizumi reined back public spending in 2003 did growth resume. Like Obama, Japanese leaders believed that infrastructure spending would boost the economy; they raised it to 6.5% of GDP, then the highest in the world – and saw the policy miserably fail.

There's a lot to like about Barack Obama, and a fair amount for investors to like about his policies. But a look at global history shows his belief that public spending in and of itself would boost the economy is contrary to reality.

[Editor's Note: Money Morning Contributing Editor Martin Hutchinson has personally interviewed the economic advisors for candidates McCain, Obama and John Edwards for our ongoing "Election 2008" series, and concluded that Obama and McCain would be the best candidates for investors. For a full report on the "presidential profit plays" that was derived from Hutchinson's research, please click here. The report is free of charge.]

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Money Morning:Election 2008: Obama or McCain – U.S. May Suffer Either Way

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